Key Surgical, Inc. (STE) Earnings Call Transcript & Summary

Good morning, everyone, and welcome to the STERIS Management Call, Key Surgical acquisition conference call. [Operator Instructions] You may also note, today's event is being recorded. At this time, I'd like to turn the conference call over to Julie Winter, Vice President of Investor Relations. Ma'am, please go ahead.

Thank you, Jamie, and good morning, everyone. We appreciate you taking the time to join us this morning to discuss our acquisition of Key Surgical. On today's call, we have Walt Rosebrough, our President and CEO; Mike Tokich, our Senior Vice President and CFO; and Dan Carestio, our Chief Operating Officer. I do have a few words of caution before we open for comments from management. This webcast contains time-sensitive information that is accurate only as of today. Any redistribution, retransmission or rebroadcast of this call without the expressed written consent of STERIS is strictly prohibited. Some of the statements made during this review are or may be considered forward-looking statements. Many important factors could cause actual results to differ materially from those in the forward-looking statements, including, without limitation, those risk factors described in STERIS' securities filings. The company does not undertake to update or revise any forward-looking statements as a result of new information or future events or developments. STERIS's SEC filings are available through the company and on our website. In addition, on today's call, we will reference adjusted earnings per diluted share, a non-GAAP financial measure. We define and reconcile GAAP and non-GAAP financial measures in today's release and in the presentation posted on our website. Non-GAAP financial measures are presented during this call with the intent of providing greater transparency to supplemental financial information used by management and the Board of Directors in their financial analysis and operational decision-making. With those cautions, I will hand the call over to Walt.

Thanks, Julie, and good morning, everyone. It is our pleasure to join you this morning to talk about our planned acquisition of Key Surgical. It's been several years since we've acquired a business of this size, and we're excited to have Key join our team. We provided a PowerPoint presentation for you to refer back to, but I will not be speaking directly from those slides. For anyone new to STERIS, our mission is to help our customers create a healthier and safer world. As our mission suggests, our customers always come first, followed closely by our people. Our belief is that if we serve the needs of these 2 stakeholders, our shareholders will receive superior returns over time. This has been a successful model for STERIS for over a decade. We've grown meaningfully, both organically and by acquisition, finishing last fiscal year with $3 billion in revenue and 13,000 associates across the globe. True to our customer-focused organization, over 3,000 of our people are in customer-facing sales and service roles, a significant differentiator in our business. About 3/4 of our revenue is in North America with the balance largely in Europe and to a lesser extent, emerging markets. Also, 3/4 of our revenue is from recurring revenue streams which are a combination of service and consumable products. We've organized our businesses around our core customer groups and report 3 business segments that represent those same 3 customer groups. Our Healthcare segment generally supports health care procedural centers like hospitals and ambulatory surgery centers. Our Applied Sterilization Technologies segment largely serves medical device companies. And our Life Science segment mainly supports pharmaceutical companies. We have a nice history of successful M&A transactions, focused primarily on adding growth by adding products and services that expand our relationships with those 3 customers and/or grow our geographic reach. Today's announcement of the purchase agreement for Key Surgical is another example of our ability to accomplish both growth approaches -- both growth approaches -- excuse me, both the expansion of geographic reach as well as adding products and services to our health care customers. Key Surgical was founded in the late 1980s. The business has grown over time organically and by acquisition, and this calendar year expects to generate approximately $170 million in revenue, entirely from recurring revenue products. Key Surgical has 3 primary areas of customer focus in health care facilities: sterile processing departments, operating rooms and endoscopy suites, the same 3 primary call points for STERIS Healthcare. Key Surgical expands, complements and strengthens STERIS product offerings around the globe. The business is nicely profitable as well, with adjusted EBIT expected to be approximately $50 million this calendar year. Headquartered in Minneapolis with a significant presence in the U.K. and Germany, we are pleased to welcome the Key Surgical people to the STERIS team, and we look forward to all we will accomplish together. This deal is all about business growth. Although there will be cost savings achieved, we expect them largely to be a function of some duplicate corporate costs and supply chain improvements. We do not anticipate significant layoffs in either organization. As we announced in our release this morning, we have agreed to pay $850 million to purchase Key. We anticipate a future tax benefit as a result of the transaction, valued on a net present value basis at around $40 million, which brings our adjusted purchase price to approximately $810 million. This translates to multiples in line with similar transactions in our space. The acquisition does require customary closing conditions, including regulatory approvals in the U.S. and Germany. We will work to close as quickly as possible and anticipate closing by December 31 of this year. Assuming that timing, we anticipate Key Surgical will add approximately $40 million to revenue and about $0.10 to our adjusted earnings per diluted share in the fourth quarter of fiscal 2021. Looking ahead, we anticipate a mix of revenue and cost synergies of approximately $10 million to $15 million by fiscal 2024. We plan to finance the transaction with debt and cash on hand, with anticipated leverage increasing to just over 2x debt-to-EBITDA following the close. This assumes we take on approximately $750 million in debt for the transaction, which we intend to finance through a combination of our existing credit facility and a new term loan with a combined interest rate of about 1.5%. In closing, we're excited about this transaction. Key Surgical is an excellent strategic fit with STERIS. It adds a significant and growing recurring revenue stream, solid profitability, and the additional ability to serve our existing call points with our health care customers. This company has shown an ability to grow at rates above industry levels due to the breadth of their portfolio, a steady stream of new products and efficient commercial model. Their focus on customer satisfaction and new products fits exceedingly well with STERIS' culture. We look forward to welcoming Key Surgical people to the STERIS team later this year. With that, Julie, would you please open for Q&A.

Thank you, Walt. Jamie, would you please give the instructions, and we can get started on Q&A.

[Operator Instructions] Our first question comes from Chris Cooley from Stephens Inc.

Can you hear me, okay?

Very well, Chris.

Congratulations on yet another very, very attractive strategic acquisition. Just 2 quick questions for me. When you look at the business of Key Surgical and its overlap with the existent STERIS franchise. I'm curious here what you view as kind of the core strategic benefits of the business. Is it a further expansion into the OR? Is it a broadening of the central sterile offering for the company? It looks like that's the largest in your segment. I'm just kind of curious what you view as kind of the standouts from Key specifically and then relative to the existing STERIS portfolio? And then I apologize if I missed this in your prepared remarks, but did you give a citation for the organic growth rate for the business? Should we assume something in line with the current STERIS Healthcare products growth rate? Or is this a faster-growing entity at this time?

Thank you, Chris. And if I recall correctly, you were a bit prescient in our conference call last time asking about the acquisitions and if we were back on the path. So I appreciate the comments. It appears -- first. That's the first question. As you probably know from me, I like deals if there's more than one reason to do them. And you've hit pretty much them on the head. It does exactly what you've described. It expands our strength in the central sterile area, which is our -- one of our key areas in our space. It grows our recurring revenue stream in the operating room and other key area for us. It also adds in the endoscopy space, which is another key growth area for us. So all 3 of those, absolutely. And I wouldn't necessarily characterize one over the other. Those procedural spaces are highly connected, and we think they will do quite nicely. I should also add, it expands our OUS footprint. They're more heavily OUS than we. We're about 75-25, they're more like 50-50. So it also expands the geographic reach. So it does all of those things, and we're really pleased. And I wouldn't necessarily characterize one over another over another. We also like a number of the things we saw from their management and the way they happen to run things. And we think that we will learn things from them and be able to do some things better with our products and probably vice versa. So I think there's a lot of positives here in the same space. Lastly, to your point, these guys have been growing more rapidly than we have on an organic basis, certainly in the double-digit range. We're thinking of them in kind of the low double digits.

Our next question comes from Dave Turkaly from JMP Securities.

You mentioned it a pretty big deal. And I'm just curious as to why now is the right time. And then as we look at the valuation, you mentioned sort of in line with some comps. We're going to call it somewhere close to 5x res. I guess just your thoughts there. I know there's a tax benefit that we could take out, would make it a little lower, but just the valuation of this -- of these assets as it relates to what STERIS has today already?

Dave, and I'm happy to respond on both. First of all, like most of the significant deals we've done, this is not something we cooked up 2 weeks ago. We've had people looking at this now for years, not months. And we were well down the path with these guys in the March time frame when we thought it made a lot of sense to hold up to see how the coronavirus issues were going to sort out. We feel much more strongly about our situation today than we did in March. And so some -- a couple of months ago, we lit this fire back up, and we're able to get it to the purchase agreement we have today. So timing-wise, we think it's a good timing. It is recurring revenue. We do expect to see recurring revenue coming back stronger and stronger over time. And so we think it's an excellent time to do the acquisition. Obviously, with the debt rates the way they are today. When you can borrow money at 1.5%, it's even more attractive in the short to intermediate term. In terms of valuations, this looks like pretty common valuations in med-tech for this kind of growth rate company. And so a, it fits the kind of the natural, the fit for a company growing like that and doing those kind of margins. And then from our standpoint, we look first at the strategic fit, which obviously, this is pretty straightforward. Then at IRRs, it certainly meets our criteria above 10%, and we get above our cost of capital in the 5-years time frame. So it meets all of our requirements as well. So we saw no reason to hold back at this time.

Our next question comes from Larry Keusch from Raymond James.

Walt, maybe -- I had a couple of questions here, but maybe just help us understand. So you indicated double-digit organic growth is what you're assuming for the business. When you look at the product portfolio, certainly, it seems fairly basic. So just trying to understand what's proprietary and what's really allowing this company to grow at that double-digit organic growth rate?

Yes. I would say, Larry, that their strengths are understanding the customer needs. And like many of our products, there's not some overwhelming proprietary nature to most of them. There are a couple that have some nice proprietary nature. But like most of them, it's not like this overwhelming. You're the only person in the market with it. It's the knowledge of some small things that make it better for users and then the complete product line and their approach to market that I think is the strength of that business at a high level.

Okay. That's great. And then the operating margins, again, which are nearly 30%. I guess how are you thinking about the sustainability of that margin profile? And then I'll just throw in the other 2 quickly, which is, are there any sales dissynergies here? In other words, is there any real overlap relative to things that you're selling? And on the financing side of the question, 1.5%, obviously, is a very attractive interest rate. But should we be thinking about that, that, that would have to be permanently fixed at some point? Just trying to understand, is that more of a short-term financing mechanism, and they'd have to be then a longer-term financing put in place.

Sure. There is some modest overlap, but the overlapping product portfolio is modest, and we don't see it being an issue. And in fact, we see it being an opportunity for a couple of reasons. One is to improve the supply chain for those products, so we have a greater volume of those where we have some overlap. And so really, we see those as a positive. And then in terms of the financing, that's an area that we clearly are looking at. We're not ready to discuss in total. But obviously, the short-term financing rates are attractive and the long-term financing rates are attractive. We're looking at all options on that question.

And our next question comes from Matthew Mishan from KeyBanc.

Congratulations on completing this deal or getting close to completing this deal. I'm sorry if I missed it, but I just wanted to understand what the COVID impact to 2020 sales and EBIT was for Key Surgical? And whether or not that 170 is representative of what they had done previously and so forth?

Matt, I would say, like in our business, it's somewhat representative. But it's not necessarily -- in total, it's representative, but it's not necessarily representative in terms of pieces. So clearly, you see that in their portfolio, they have some PPE. As you might expect, their PPE is stronger than normal, just as we've seen in our AST business and just as we've seen -- and we've seen the strength in our Life Science business. On the other hand, the -- a number of the pieces of their business are related to procedures. And as procedures fell off, they saw a decline in that procedural volume. But we have looked at that and feel comfortable that we understand the go-forward look at those revenues, and it's not out of the ballpark as a guide.

Did the mix have any impact on EBIT and the margin profile?

Not consequential.

Okay. Okay. Excellent. And then I think this is the first deal I've seen you guys do in endoscopy, I think, since US Endoscopy, way back. And it's nice to see you guys had some more scale to that call point. What does that look like for you now post this acquisition?

Well, we like the endoscopy business. We have done some small tuck-ins into that business that we've not necessarily reported on. So we have continued to add product line, both organically and through tuck-ins. And this fits very nicely with that situation. So it does expand our product portfolio. And endoscopy gives us strength and also particularly had strength in the -- outside the U.S. business. So in those cases, it really does add. So we think this is a very nice fit with our endoscopy business. As you know, we don't split out the components inside of health care. But that still has tended to be a high grower for us, and this continues to add to that, and that's one of the reasons that their growth is so nice since that's been a nice growing space.

Okay. And just last question. Said over half of the revenue is outside the U.S. on this. Does it open up any geographies, any opportunities out of the U.S. that you might not have had a previous opportunity for?

Yes. I would say they have some dealer relationships in, I'll call it, the same kind of places where we tend to have dealers. So that always is a potential add, and that's a nice upside for us. But in addition, and more importantly, on the European continent, they have some real strength. So we think that will help us in our movement there.

Our next question comes from Mike Matson from Needham & Company.

I just wanted to ask a question related to the integration. So you mentioned there really weren't going to be any layoffs for the most part. But can you just talk about on the sales side, how the 2 companies sold the products and how those sales teams will kind of be put together?

Yes, I'm going to turn that to Dan and Chris. Dan has been working more deeply on a one-on-one basis with those folks and is helping to lead the integration process. So Dan, if you would pick that one up?

Yes. We feel like there's a real opportunity there with their model, which is much more of an inside sales-type approach and then followed up with a lot of very, very good hands-on clinical work directly with customers, especially when dealing with these type of products. And contrast that to our field organization, which is much more in-the-field direct-type rep-type approach. So we think the 2 are completely complementary, especially as we look at our consumable offering.

Okay. That's helpful. And then just on this tax benefit. So I would assume that, that reduces your cash tax rate, but it wouldn't really affect the tax rate on your P&L, is that right or?

Yes, Mike, this is Mike. That is 100% correct. So the tax benefit actually relates to our ability to deduct goodwill, and that amortization is about 15 years. We may be able to get some of that earlier if possible, but generally, it's a 15-year amortization.

Okay. And then just one follow-up on the financing. So I think you said and how much you expect it to be cash and how much you expected it to be debt. Can you just repeat that? And then the interest rate you mentioned was 1.5%. I think that was on the term loan. What's the rate on the credit facility portion?

Yes. So just a recap on the funding. So what we did for the $850 million transaction is we're using $100 million of cash on hand, $200 million borrowings on our current credit facility. And then $550 million 3-year term loan. Both the credit facility and the 3-year term loan are floating rate, and that is about 1.5% in total.

[Operator Instructions] Our next question comes from Michael Polark from Baird.

Just a couple of cleanups here. The $10 million to $15 million of synergies, I just want to make sure I heard that correct. That includes some revenue and cost elements. Is that accurate? Or is that entirely a cost number?

It's actually the profitability on revenue and costs. So you can think of it as an EBIT kind of number. The mix of revenue and cost.

Okay. All right. Helpful. And then as you roll the balance sheet forward to just north of 2 turns of leverage, just curious for comfort at that level on future capital deployment? Is this a big enough bite such that heads down for a period of time while you're integrating and growing and growing again into the balance sheet? Or do you feel like you have flexibility to stay in the M&A market in 2022 -- or excuse me, in 2021?

Yes. We definitely don't see this as a cutoff point. We were in our view, underlevered. And particularly as we have continued to move our portfolio to more and more recurring revenue as opposed to capital where we have to be a bit more careful from an operating standpoint because capital tends to come in bunches a little more than recurring. So we feel certainly comfortable in the 2.2 range. It's kind of a -- that's 2.20, 2.3, 2.4 is kind of a normal range. But we are very comfortable going up beyond that. You may recall, when we did synergy, we moved up around 3, and that certainly didn't cause us discomfort as long as we find a way to get back down closer to 2.

Maybe if I can sneak one more in, unrelated to the deal. I noticed no comment on September results, I suspect you might defer any comments on this question, but curious how you see the world, the base business performance through the end of the September quarter, current trends, anything of that sort would be welcome, although certainly understand if the comment is no comment.

You're a prescient as well. We're 4 days in -- after the end of the quarter, and we don't have the final numbers ourselves, and we're looking at what our thinking is in terms of forecasting. So we won't have any comment in that regard. I will say, though, if you look back at our comments in August, I wouldn't characterize us as feeling radically different than we did back then.

[Operator Instructions] Our next question is a follow-up from Chris Cooley from Stephens Inc.

Just wanted to clarify, if I could, Walt. When you look at the Key Surgical franchise, could you help us with the relative weightings across their 3 primary product categories, the sterile processing, the OR and the endoscopy businesses. And then similarly, could you help us with existent customer overlap? I'm curious how much of your footprint is the same as theirs, whether there's immediate synergies versus where there's opportunities to cross-sell?

Yes. So this -- Chris, this is Dan Carestio. And it's not quite 1/3, a 1/3. They're probably largest segment is in the SPD area, in particular, in the U.S. And then sort of second and that -- and it's very strong in Europe, in particular. And then the OR type products, it would be the third largest, that would probably bank up about 20% of their sales. So that's kind of the breakdown as we look at it.

Thank you. And ladies and gentlemen, at this point, showing no additional questions. I'd like to turn the conference call back over to Ms. Winter for any closing remarks.

Thanks, everybody, for taking the time to join us this morning. We look forward to catching up with you all soon.

And ladies and gentlemen, with that we'll conclude today's conference. We do thank you for attending. You may now disconnect your lines.